BAE Systems braced for another spending review

Guidelines for future export contracts could be key to the future as more belt-tightening grips Whitehall. Roland Gribben reports

Britain's biggest defence manufacturer, BAE Systems, earned praise and criticism for its decision to throw the issues of arms and ethics firmly into the moral arena by inviting Lord Wolff, former Lord Chief Justice, to review its behaviour in the complex world of defence contracts.

The findings and admissions of shortcomings in the way it won some orders were hardly surprising, but the question now exercising business and political minds is whether more changes are needed in the rules and guidelines covering export contracts. Earnings from defence exports are an important source of revenue and influence.

Around 40pc of the industry's output finds its way into the defence and service operations of foreign governments, providing a considerable flow of earnings that reinforce research and development investment capable of producing spin-offs outside as well as inside the defence parameters. Exports are set to become even more important for a sector nervously waiting the outcome of yet another Ministry of Defence (MoD) spending review.

Sizable expenditure cuts linked to delays or cutbacks in key projects are on the cards as civil servants and ministers wrestle with Treasury demands for economies and the front-line needs of troops in Afghanistan and Iraq as well as the defence industry's need for certainty rather than uncertainty. An exercise under the riveting title of PR09 - procurement 2009 in longhand - is currently preoccupying defence chiefs and teams of civil servants.

Rear Admiral Rees Ward, director-general of the 500-strong Defence Manufacturers Association (DFA) and a veteran of earlier spending inquisitions during his 40-year naval career, says his members are waiting anxiously for the outcome. "The ministry have black holes in their budgets and they are not going to get any more money from government to fill them. The government has other higher priorities so belt tightening is the order of the day,'' he said.

"The ministry has a number of large programmes that are going to be delayed. That's the alligator closest to the canoe. Waiting for the decisions is affecting our members most. Indecision is not helpful, but the Government has a helluva dilemma. Sooner or later, they're going to have to say what the decisions are and that's the thing we are focusing on right now.''

DFA members are heavily populated among the small and medium-size defence suppliers but the effect of cutbacks will be considerable throughout the chain. The timing of the contract for two aircraft carriers is one of most important decisions - for BAe Systems, VT and a throng of suppliers - on the PR09 agenda. There are a host of other smaller contracts crucial to DFA members.

Ward says: "If there is belt-tightening there's likely to be rationalisation and job reductions around the place. That's the general feeling at the moment. But we're the secon biggest defence exporter in the world and there's opportunities out there for us. Exports mean we can sustain a larger research and development capability and makes us more agile and responsive from a larger industrial base.

"It means we can respond immediately to front-line demands for example, but if you shrink that industrial base you get less innovation and that's part of a downward spiral.'' Defence spending currently represents nearly 6pc of total government expenditure. Whether that ratio is retained depends on the outcomes of the spending review.

On current plans, the defence budget is set to increase from a base line of £ 32.6bn in 2007-08 to £ 36.9bn in 2010-11, representing growth of 1.5pc a year after allowing for inflation. The MoD says that by the end of the period the budget will have grown by 11pc in real terms compared with 1997, the longest period of sustained growth since the 1980s.

The defence business and its related services touch almost every part of an industrial chain with two powerful international groups at its head. BAE Systems alone estimates it provides direct employment for 35,000, makes a £ 2.4bn-a-year contribution to the economy, has export earnings topping £ 4bn, pays almost £ 500m a year in taxes and splashes out nearly £ 900m on research and development.

One single figure provides a dramatic insight into the importance and contribution of Rolls-Royce in the world of aero-engines. Orders in one month alone this year for civil and military applications totalled £ 7.7bn. BAE has made great efforts to identify in detailed terms its economic importance to UK plc to help counter the criticism and allegations involving the circumstances surrounding Al-Yamamah, the £ 42bn defence contract with Saudi Arabia that provided a lifeline for the group over the past decade.

With the help of Oxford Economics, BAE estimates that its direct and indirect contribution in employment terms represents more than 105,000 jobs along with £ 790m in taxes and more than £ 5.8bn in value added. Productivity, measured in terms of value added per employee, worked out at £ 69,000 a head in 2006, more than 70pc above the national average and higher than the achievements in the business and financial services industry. Staff productivity has increased by nearly 20pc since the start of the decade.

In regional terms, the North West represents BAe's heartland, accounting for about half its total UK employment. Just under 3pc of knowledge-intensive private sector jobs in the region are directly attributable to the group, rising to almost 12pc when knowledge-intensive production centres are included. BAe and its partners in the defence business argue that they deliver value for money. The MoD has its reservations and so does the Commons Defence Select Committee.

Its most recent report again highlighted the three biggest contract headaches - the Astute submarine, Type 45 destroyer and the Nimrod MRA4 programmes. Their cost is almost £ 3bn above budget while service delivery delays at end March last year were running at 166 months, equivalent to almost 14 years. The MoD is looking to Defence Equipment and Support, formed by merging the Defence Procurement Agency and the Defence Logistics Organisation, to deliver improvements.

At the time of its merger a year ago, the new organisation had 29,000 staff on its books and a budget of £ 16bn - more than 40pc of the defence budget. General Sir Kevin O'Donoghue, head of the new set-up, has produced a business strategy covering the next four years. It sets demanding targets, including a reduction of 9,000 in staff numbers. Achieving them means more testing times for BAE and the supply network.